Our previous post described the tax hit that many fixed income investors are experiencing due to higher interest rates and two strategies for tax savings. You can catch up here.
Today we highlight three more strategies.
Switch to return of capital mutual funds
Return of capital (ROC) mutual funds (also called T-SWP, T-series or T-class) allow investors to receive distributions made up of their own capital on a tax-deferred basis. It’s important to understand that ROC distributions are above and beyond what a mutual distributes as income, dividends, or capital gains. Unfortunately, ROC distributions don’t allow you to avoid paying taxes on these regular taxable distributions.
ROC distributions are appealing because they’re tax deferred. Rather than getting taxed in year they’re received, they reduce the investor’s adjusted cost base (ACB) by the amount of the distribution. If enough ROC distributions are received, you’ll eventually end up with an ACB of $0. At that point, any future ROC distributions are fully taxable as capital gains. Once an investor sells their position, they’ll trigger accrued capitals gains at that time. Your realized capital gains are calculated as the difference between your sale proceeds and your adjusted cost base.
The percentage of distributions a mutual fund pays as ROC will vary from year to year and it isn’t known in advance. Distributions from a mutual fund are rarely 100% ROC because the fund typically generates some taxable distributions in the form of interest, dividends or capital gains. Upon request, a mutual fund company will provide a breakdown of their historical distributions so that you to assess their track record.
Many mutual funds offer an ROC version of their mandate. Once an investor is ready to start pulling from their non-registered portfolio, it’s worth asking if any of your existing mutual funds offer an ROC version of your holdings. If they do, in many cases, an investor can do a tax-free switch to the ROC equivalent fund. You’d then instruct the fund company to stay paying out a set monthly distribution. ROC distributions can usually be customized to best suit your cash flow needs, up to a maximum of 8% annually.
ROC mutual funds are best suited to investors who are regularly drawing from their non-registered portfolio and who also have substantial accrued capital gains. Because this strategy involves deferring capital gains to a future date, you need to ask yourself if it’s beneficial to defer this taxable income to the future. The higher your current marginal tax rate is and the more it’s projected to decease in the future, the more appealing ROC mutual funds become.
Buy prescribed annuities
Rising interest rates have led to a renewed interest in annuities.
Annuities are insurance products; in exchange for an upfront lump sum of money, the insurance company provides you with a steady guaranteed income stream. This income stream can be set for a specific timeframe or for life. One of the factors that impacts how much you’ll receive in annuity payments is interest rates when you purchase your annuity contract. In a higher interest rate environment, you can get a comparatively better payment from a new annuity than one that was purchased in a low interest rate environment.
Annuities can be purchased with either registered or non-registered assets. If you use registered funds, your annuity payments will be fully taxable as income. If instead you buy an annuity using non-registered funds, you have the option to buy a prescribed annuity.
With a prescribed annuity, fixed annual payments are made up of interest and your original principal. This means that only part of the annual annuity income is taxable. Prescribed annuities receive preferential tax treatment that allows them to level out your taxable annuity income for the entire length of your contract. If an annuity isn’t prescribed, you’ll pay more taxes sooner because interest gets calculated on an accrual basis. As a result, earlier payments are mostly comprised of taxable interest income. Over time, the percentage received as tax-free principal gradually increases. The preferential tax treatment of prescribed annuities results in overall tax savings for the annuity recipient. It’s worth clarifying that not all non-registered annuities are prescribed annuities; they need to meet certain criteria to qualify for this preferential tax deferral.
A prescribed annuity may be a good option if:
- You’re about to start (or have already started) receiving regular non-registered portfolio withdrawals to fund living expenses.
- You have limited guaranteed income sources (such as CPP, OAS or defined benefit pensions) and are concerned about outliving your savings.
- You are risk averse and/or want to have a fixed and reliable income source.
- You’re in a high marginal tax rate and tax minimization is a priority for you.
When purchasing an annuity, it’s rarely an all or nothing decision. Most annuity investors are best served by only allocating part of their assets to an annuity, while leaving some liquid assets otherwise invested. This approach ensures that they’ll continue to have funds available for irregular or unforeseen expenses. These funds also create a potential residual estate value, which is especially important for those who’d like to leave a legacy after their passing.
Before purchasing an annuity, we recommend having an up-to-date financial plan in place that projects your future cash flow needs. This will help you determine a reasonable lump sum for an annuity contract. You’d then ask an insurance licensed advisor to get quotes comparing payments from various providers that outline the cost of optional features, before choosing the best contract for your needs.
If you think an annuity might make sense for you, please don’t hesitate to reach out. We have licensed insurance advisors on our team who would be happy to explain annuities further and help you assess if an annuity makes sense for your circumstances.
Hold bonds and GICs in registered accounts
In a perfect scenario, you’d reduce or eliminate taxes on your investment earnings by holding these assets in a registered account. To recap, assets held in a TFSA benefit from tax-free growth and future withdrawals are completely tax-free. Assets held in an RRSP/RRIF growth tax-deferred until these funds are withdrawn as fully taxable income.
In practice, most investors hold assets in non-registered accounts because they don’t have enough registered contribution room to tax-shelter all their investments. In these cases, one solution is to strategically hold less tax-efficient investments such as bonds and GICs in registered accounts, while holding more tax-efficient assets like stocks in non-registered accounts.
Though this strategy is appealing in theory, unfortunately, it’s often not practical to implement. Registered accounts are attractive because of their ability to compound tax-deferred growth year over year, sometimes for decades. This means they’re often best suited for more aggressive investments with higher return potential (such as stocks) that are earmarked for long term savings. By comparison, non-registered accounts are often the first source of funds for short-term cash flow needs or unforeseen expenses. As a result, they tend to have a higher percentage of their assets in more conservative (and less tax-efficient) investments like GICs and bonds.
If you happen to have any unused TFSA contribution room and you also have non-registered assets, you should consider using your non-registered assets to maximize your contribution room. Even if these assets are for the short term, you can open a 2nd TFSA for the short term portion of your savings to easily distinguish between your different investment objectives. When you withdraw these funds tax-free, the good news is that you’ll get this TFSA contribution room back on January 1st of the following calendar. Unlike with a TFSA, using non-registered funds to maximize RRSP contribution room isn’t always advantageous; before making an RRSP contribution, you need to analyze how likely is it that your marginal tax rate in the year you claim your contribution will be higher (or at least equal to) your projected marginal tax rate when you withdraw these funds.
Finally, before transferring non-registered assets to your registered account, you’ll need to assess the tax consequences of triggering a deemed disposition. Even if you maintain exactly the same investments, moving non-registered assets with accrued capital gains will trigger a deemed disposition, which is a taxable event. For investments with accrued capital gains, depending on the size of the gains, your marginal tax rate, and whether you have any unused capital losses you can claim, you may be better off leaving your non-registered assets where they are.
Don’t let the tax tail wag the dog
In closing, despite the unpleasantness of paying taxes and the numerous strategies available to minimize taxes, it’s important not to lose sight of the big picture. In all but the rarest of cases, taxes should not be the primary driver of your investment strategy. Instead, the tax implications of your investments should be considered only after your investment objectives, investment time horizon and the suitability of potential investment products have been considered. After all, it’s always better to pay taxes on investment earnings than to owe no taxes because you experienced losses in your portfolio.
If you think you might benefit from some of these tax planning strategies, speak with your financial planner for customized advice.
This information is of a general nature and should not be considered professional advice. Its accuracy or completeness is not guaranteed and Queensbury Strategies Inc. assumes no responsibility or liability.
